To QE, or not to QE, that is the question

26th June 2012

Monetary Policy Committee member David Miles has called for an additional £50bn in quantitative easing. His comments come as the Swiss-based Bank for International Settlements (BIS) said that quantitative easing was putting the UK economy at risk by propping up ailing banks. The recent fall in inflation makes additional quantitative easing more likely – what are the arguments for and against such a move?

David Miles has been seen as the most dovish member of the Monetary Policy Committee and voted in favour of more quantitative easing at the most recent meeting: "He said: "Do we need a more expansionary monetary policy? ‘Yes'. Should it be a substantial change in asset purchases? ‘Yes'. Is £50bn a substantial number? ‘Yes it is'. Could one know in advance what is exactly the right amount to do? ‘Absolutely not'."

A renewed round of quantitative easing has been seen as more likely after the last set of inflation figures, which showed CPI lower than expected on the back of weaker commodities prices.

However, the Swiss-based Bank for International Settlements (BIS), the world's financial regulator, has said that continued quantitative easing risks ‘masking lenders' bad debts and deterring them from cleaning up their balance sheets.': "Prolonged and aggressive monetary accommodation may delay the return to a self-sustaining recovery," BIS said. "It can undermine the perceived need to deal with banks' impaired assets."

It was damning of the response by governments: "The extraordinary persistence of loose monetary policy is largely the result of insufficient action by governments in addressing structural problems," it stated. "Simply put: central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed. This intense pressure puts at risk the central banks' price stability objective, their credibility and, ultimately, their independence."

The report found resonance among many on the comment boards. Triplicity said: "And that…is the most sensible and correct analysis I have read in years of obfuscation and misdiagnosis. The only recovery worthy of the name is a self-sustaining one and cannot occur until debt deleveraging, writeoffs, forgiveness and restructuring have taken place."

For some time inflation has been seen as the most likely and potent side effect of quantitative easing. Yet Keith Wade, chief economist at Schroders suggests that inflation, for the time being at least, has not been a side effect of the Bank of England's policy.

He says that inflation will only become a worry if the velocity of money (the speed at which it moves round the economy) increases and there is a hike in inflation expectations. At the moment, he says, "whilst the expansion in the monetary base via QE I and II is unprecedented, it has led to a huge decline in velocity. The monetary base of the US has at least doubled since the Federal Reserve (Fed) embarked on the first round of QE, but the velocity of money has fallen by around two thirds in this time."

A recovery in lending in the banking sector is usually a sign of a turning point in the velocity of money. This is happening tentatively in the US, but not enough to make a real impact on inflation. He believes the real risks lie in a potential policy error or that policymakers become tolerant of higher inflation.

The real dangers associated with quantitative easing appear to lie elsewhere. For example, Chris Poll on the Financial Times community, says that QE is, at best, a crude tool: "MPC members are being irresponsible..how can a responsible body like the Bank of England relax liquidity and capital controls for lenders and offer subsidised finance without ensuring banks improve their systems infrastructure – especially upgrade their methods of assessing, pricing and monitoring risk?" He points to the recent NatWest debacle as a sign of the decaying banking systems infrastructure.

On the same site narnia2000 says: "Is it just me that sees a correlation between continual currency devaluation and higher inflation? And if we intend to erode Sterling to make the UK more attractive for manufacturing, we'd better speed up the process if our largest trading partner continues its deflationary spiral because £50 billion is not a significant number if we're trying to keep pace. Therefore, we make our situation worse with half-baked QE measures. It's either too much or too little but serving no real economic purpose in its current state."

Another round of quantitative easing may be the only policy option open to central bankers running out of ideas in the absence of creative government policy. However, many see inflation as the only risk, but as BIS and others suggest, the real risks may lie elsewhere.